Why energy prices have risen so much

In the midst of current debates about energy costs it is important to retain a sense of perspective both about what has happened and future prospects.

One key factor is that the UK became a large net importer of gas in 2005. As a consequence, gas prices in the UK market are now determined by import costs rather than by demand and supply within the UK. This transition coincided with a sharp increase in international oil and gas prices from 2004 to 2008. Gas prices in the UK reached a peak in 2008 but fell in 2009 due to the financial crises and have remained below the 2008 level since then. However, the UK has not benefited from the huge expansion in shale gas production in the US, partly because import and storage capacity for liquefied natural gas (LNG) is limited and partly because of high demand for LNG in Japan and East Asia following the closure of nuclear plants.

Improvements in operating efficiency were partly achieved by deferring investment in the replacement and expansion of networks. As the UK relies more on imports and renewable energy, the level of investment in storage, pipelines and electricity networks has to increase. The regulated costs of greater investment are passed on to customers through charges for network use. This will continue for the rest of this decade. Indeed, some believe that the UK needs more investment than is currently planned to expand gas storage and provide greater security of supply in future.

The third factor driving up energy prices for households and some businesses is the increasing cost of programmes to reduce emissions of CO2 and to promote the use of renewable energy. These goals overlap but they are not identical. The expansion of renewable energy is an expensive method of reducing CO2 emissions and would not be the first choice if this were the sole objective of policy. Both goals are supported by a plethora of incentives whose details are often obscure and whose net impacts are hard to assess. In addition, some costs of relying upon renewable energy, such as backup to offset intermittent production and extensions to the transmission system, are incorporated in charges borne by all network users.

To meet 2020 targets for renewable energy, the share of renewables in total electricity production will increase to three times its level in 2012-13 and the share of renewables in electricity, heat and transport will increase to nearly four times its level in 2012-13. Since this growth can only be achieved by relying upon increasingly expensive sources, the targets mean energy costs will increase by at least 3% per year on top of inflation. In practice, the effective increase may be significantly higher than this estimate.

Natural gas is the key benchmark for energy prices in the UK because of its role in domestic heating and electricity generation. Sharp increases in international prices in 2008 (due to demand from China) and again in 2011 (due to the Fukushima earthquake) have been passed through to UK consumers. In the longer term it is policy decisions that are the major source of increases in the prices paid by households in the UK. Better insulation and other investments in energy efficiency can achieve one-off reductions in energy use, but above-inflation increases in energy prices are an unavoidable consequence of current commitments to expand the share of renewables in energy production and reduce CO2 emissions.